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What the SEC Should Learn from Raj Rajaratnam and the Galleon Group

The government's case against Raj Rajaratnam, founder of hedge fund Galleon Group, on the charge of insider trading, alleges that the hedge fund manager's primary competitive advantage for investors was a web of connections close to or inside technology companies feeding him illegal tips on future directions of the companies' stock prices.

What's shocking is how Rajaratnam is accused of having, over at least 10 years, cultivated a network of insiders feeding him nonpublic information about future earnings announcements from public companies like AMD (including its former CEO), IBM, Intel (INTC), and some of their most prestigious advisers like McKinsey & Co.

Why would so many bright, high-ranking people at such successful companies get caught up in such activities? Perhaps they craved access to a man whom Forbes recently ranked as the 262nd richest American, worth $1.8 billion and in the top 40 of hedge fund managers.

In a recent PBS "Frontline" episode on Alan Greenspan, the program made the allegation that the former Federal Reserve chief and acolyte of free marketer Ayn Rand had once joked with former head of the CFTC, Brooksley Born, that the two of them would never get along because she believed in prosecuting capital markets crimes and he didn't. He supposedly went on to explain that his strong faith in free markets made him believe that it was unnecessary to go after white-collar criminals through any kind of enforcement program.

Instead, Greenspan believed that market participants would ferret out ill-gotten gains and punish those people for their crimes by starving them of future capital. Such efficiencies would likely occur before the governmental regulatory body even knew something nefarious was going on.

Although I'm a proponent of unencumbered free markets, this point of view, whether Greenspan held it or not, is laughable. Bernie Madoff has blown this argument out of the water. And now we have the case of Rajaratnam, his decade old hedge fund, and his alleged 10 years of generating alpha through profiting on illegal insider information.

As a hedge fund manager, I look positively on this development. If illegal activity is going on by fund managers, it deserves to be highlighted and prosecuted. Investors will learn to ask tougher questions as part of their due diligence, and capital will ultimately flow away from managers posting false performance numbers to those who are truly generating alpha.

The hedge fund industry has to be one of the most Darwinian industries of any in the world. You don't get to keep your job by being the boss' son or being friendly with the right managers above you. You get to keep your job (and paid well if you do it consistently) by beating the market. You lose your job otherwise.

Perhaps because of the big potential rewards for success, it shouldn't be surprising that some aspiring and existing managers would try to bend the rules to get or stay on top. What this case shows is that ethical managers and investors are better off with a strong enforcement office at the SEC. The industry itself is not going to highlight the next cheater and investors -- even very sophisticated ones -- cannot do this themselves.

I know many hedge fund managers who've expressed mixed feelings about the Galleon case. They're happy that illegal activities by their competitors are being halted, but they worry the case will inspire more unnecessary red tape and heavy-handed oversight. The SEC is faced with a challenge in keeping ahead of the latest and greatest tricks employed by some managers to gain a performance edge.

However, the agency appears to have been pretty creative in coming up with some ways of identifying and tracking alleged illegal behavior in the Galleon case. Hopefully, it will begin to hire more people in the enforcement division with real-world Wall Street experience and not just more bureaucratic lawyers, as was criticized by Harry Markopolos in the Madoff case.

There's been a lot of discussion of getting hedge funds to register with the SEC as an important way for the agency to keep tabs on the potential risk these funds pose to the financial system. It's important, therefore, to realize that Galleon was registered -- its assets under management at one point last year topped $3 billion. More budget resources targeted towards enforcement would be taxpayer money better spent than registration for registration's sake.

Finally, a word of caution on the Galleon case. Although criminality ought to always be prosecuted to the fullest extent, Galleon and Rajaratnam deserve the right to defend themselves in court. What if they are innocent, after having announced they would be winding down the firm two business days after news of the arrests first broke? Could they ever truly be made whole by the SEC if that happened? That Orwellian possibility should send shivers down the spines of hedge fund managers everywhere.

Mark Cuban has never run a hedge fund, but what if he had when the SEC came after him last year for purportedly trading on insider information in the small-cap stock Mamma.com? If he'd had a hedge fund at the time, it likely would have also had to be wound down when details of his arrest first emerged. The SEC later dropped the charges, although it recently made some noise about bringing them back.

Wrong-doing deserves to be regulated and prosecuted by the SEC. The government should devote more resources to enforcement with the best qualified people involved. A few correct convictions will have a ripple effect throughout the hedge fund industry and discourage illicit behavior.

However, the SEC needs to realize it is playing with people's lives and livelihoods here. Investors will -- understandably -- redeem first and ask questions later when the agency launches actions against a fund or fund manager. They have a responsibility to do their jobs to the best of their abilities, as do hedge fund managers and senior executives within public companies.

Disclosure: Jackson's fund holds no positions in the stocks mentioned.